Research on Index Insurance: What do we know and what do we not know?

Farma Bagayoko works in a greenhouse filled with tomatoes at the Sidibe Argo-Techniques in Katibougou Village, outside Bamako, Mali on November 3, 2013. Sidibe Argo-Techniques is growing watermelons, sweet peppers, tomatoes and other vegetables. Photo © Dominic Chavez/World Bank

Interview with Xavier Gine, Lead Economist within the World Bank Research Department (DEC).

1/ What do we know about index insurance after about 10 years of experience?

There has been a lot of research around the question of take-up and impact of index insurance. Despite the potentially large welfare benefits, voluntary take-up of index insurance products has been rather limited so far.  Explanations for this low demand could include:

  • The first reason is that the product may be expensive, relative to the existing risk coping strategies. After all, when it is not subsidized as is the case for several states in India, average payouts based on historical rainfall data relative to premiums are about 30 to 40 percent. Index insurance premiums are above actuarially fair prices because of several reasons (uncertainty loads due to lack of data, transaction costs, taxes, lack of competition etc..) but even if prices were close to actuarially fair, demand would not increase enough to be close to universal participation. So the price cannot be the whole story.  Demand for insurance usually can increase if it is linked to a package of financial (loans) and non financial services (access to technology, capacity building, inputs, markets) where insurance is a value-added service on top of a package offered to these farmers.
  • A second reason is liquidity. Farmers purchase insurance at the start of the growing season when there are many competing uses for the limited cash available. Providing liquidity at the time of insurance purchase increases take-up and this effect is concentrated among poor households, who are likely to have less access to the financial system.  Programs that link loans to insurance could add the premium payment in the loan amount with repayment after harvest when the borrower has liquidity. 
  • A third reason is trust. Unlike credit, where the lender needs to trust the borrower that the loan will be repaid, insurance requires the client to trust the provider that it will honor its promise in case of a payout. When the product is endorsed by a trusted local agent demand is significantly higher. Trust may be particularly important because many households have only limited numeracy skills and financial literacy, likely reducing their ability to independently evaluate the insurance.
  • A fourth reason is salience and convenience. Sometimes little things in the way the product is sold can make a big difference.  Awareness raising campaigns, financial education, convenient distribution and payment channels (e.g. mobile and digital networks) could be among the activities that contribute to a bigger uptake. 

2/ Any finding a bit more counter-intuitive?

One of our biggest surprises was our research in Malawi that showed that index insurance bundled with credit was not necessarily attractive to farmers. In this project, a standard loan was bundled with insurance creating a contingent loan, one that it had to be repaid only when the payout was not triggered (when rain and thus harvest were good). Demand for such contingent loan should be higher because it would be more valuable to risk averse borrowers that feared having to repay the loan even when the harvest was low, and it addition, the premium for the insurance did not have to be paid upfront but was part of the loan, solving the liquidity problem. Much to our surprise, we found that demand for the bundled loan was lower than that of a regular loan (17.6 percent uptake vs 33 percent). The reason was perhaps because the lack of collateral and the lender’s inability to sanction defaulting borrowers was already providing implicit insurance and so farmers did not value the insurance policy. What is remarkable about this context is that, even though lenders knew that bundling loans with insurance would probably not increase take-up, they still decided to do it, as an internal risk management tool. To them, rainfall insurance proved to be an attractive way to mitigate the risk of credit default and had the potential to increase access to agricultural credit at lower prices.

3/ The fact that voluntary take-up is low begs the question of whether insurance is at all valuable, doesn’t it?

Yes, insurance is valuable! Individuals offered insurance do shift production towards more profitable but riskier activities, thus capitalizing on insurance. This is prima facie evidence that individuals are not fully insured using the existing risk-coping arrangements.

4/ What do we still not know about index insurance?

I think that we need more research on the role of aggregators. There have been new distribution approaches that have been tested at “meso-level”, where insurance policies are targeted to groups, such as an entire village, a producer group or a cooperative, or loan portfolios of financial institutions, rather than to individuals. This approach might help reach scale quicker, with lower transaction costs, potential crowding-in of informal insurance and increased coverage. When I say “crowding-in of informal insurance”, I am referring to the fact that if only a few individuals buy formal insurance then informal insurance arrangements may break down. Indeed, individuals that are covered with formal insurance may be reluctant to participate in informal insurance arrangements, while other villagers may try to tax away the payouts. However, group or collective coverage may encourage informal mutual type of arrangements that could break down if the majority of people suffer at the same time.  Index insurance could provide protection to the groups for such wide systemic risks.  Groups also could take care of distributing payments according to needs thus providing a solution to the basis risk problem. 

For financial institutions though there is a dilemma.  If the borrower is aware that the lender has a coverage but the lender does not tell what will happen to the loan when production losses occur, the culture of repayment maybe undermined. For example in Malawi, one region of the pilot experienced a mild drought that only triggered a small payout, but since farmers were told that there was a payout, they assumed that it would cover the whole repayment amount and thus defaulted on their loans.  For lenders that take up a portfolio coverage it will be important to establish the rules and communicate them clearly to the borrowers of what happens once insurance gets triggered. 

5/ What do you think is the key challenge ahead?

My main concern about the development of agriculture insurance is the risk that market forces lead the industry to design sub-optimal products. In the context of a willingness to pay for insurance study we found that while customers were willing to pay more for insurance products that offered more coverage, they were less sensitive to changes in contract terms that are relevant for extreme events. Put differently, they would value more a policy that paid more often but a lower amount when a catastrophic event takes place than another that only paid during catastrophic events. This has interesting implications for the pricing of policies and thus for the quality of the insurance products offered as insurance providers may be targeting more the wants rather than the needs of individuals. As the industry matures, this issue is worth looking at closely.